Sep 12, 2018 Andrew Bartolini
Enterprises around the world want to maximize working capital for a variety of reasons, not least of which includes freeing up cash from operations in order to hire new employees, pay down debt, expand into new markets, or even to provide better returns to shareholders via dividends and stock repurchases. Working capital management is thus an important facet of the modern enterprise’s concerns. One method to impact working capital is by capturing early payment discounts, which can provide a valuable cash return to the enterprise. To illustrate, today we’ll go through a detailed example of an early payment discount as well as outline how to wrangle more early payment discounts.
What is an early payment discount?
At its most basic level, an early payment discount is a particular set of payment terms that suppliers offer to buyers for paying invoices within a specified time frame that’s shorter than the agreed-upon payment terms. Standard discounts are represented in the form of a percent off within a specified number of days, followed by when the full payment is due. A discount of 2% paid within 10 days on an invoice that comes due in 30 days is thus represented as 2/10 net 30. A discount of 1% in 10 days on 30-day payment terms is 1/10 net 30, and so on for other types of payment terms.
Suppliers offering early payment discounts do so for a few reasons. Two such reasons are that early payment discounts allow suppliers to receive cash sooner, which as a byproduct shrinks days sales outstanding (DSO), and that these discounts may engender some loyalty among the customer base.
Why are early payment discounts valuable?
Suppliers that offer early payment discounts benefit from receiving payment sooner, which increases their working capital stores and decreases DSO. Of course, suppliers receive less than the full amount of the invoice under this program, but receiving a lower fee in this manner can be cheaper overall than their other sources of credit like traditional receivables financing or factoring.
Buyers appreciate early payment discounts because of, among other reasons, the annualized rate of return. Traditional savings instruments, such as money market accounts, continue to remain stubbornly below 1% annual percentage yield. Early payment discounts, on the other hand, can provide much higher returns; for example, a 36.73% annualized rate of return can be earned on a 2/10 net 30 early payment term paid on the 10th day. Assuming for a moment than an enterprise has a $10,000 invoice that’s eligible for early payment, paying early will result in an invoice payment of $9,800, which saves the enterprise $200 on that single invoice. Basically, the enterprise saves $200 by paying 20 days early; the payment had to be made anyway, but the difference is that the enterprise saved $200 in exchange for not holding the cash. (The formula for annualized rate of return, incidentally, is amount of discount divided by discounted price multiplied by number of days in the year divided by number of days paid early.)
A savings of $2,400 doesn’t seem like much on its face, but capturing early payment discounts on multiple invoices can add up quickly over the course of a year. The traditional investment vehicles that treasury would use offer less return by far than an early payment discount. Consider that, as of December 18, the highest potential return on a money market account was 1.05% APY, the 6-month LIBOR has a return of 0.34%, and the overnight rate is 0.03%. None of these even approach the 36.73% risk-free annualized rate of return that an early payment discount provides.
Early payment discounts can thus provide significant cash return to enterprises, and the accounts payable and treasury teams would be remiss to ignore the possibility of capturing these discounts more effectively. Everything’s not all bread and roses, however, as we’ll soon see.
What are the challenges of early payment discounts?
Early payment discounts, while valuable and mostly risk-free ways to grow enterprise cash, aren’t perfect for every enterprise. Because capturing discounts involves paying suppliers sooner than the agreed-upon terms, the buying organization shrinks its days payable outstanding in the specific instance where the buyer captures a discount. For enterprises with tight cash flows, paying an invoice early may not always be possible. Similarly, the standard early payment discount of 2/10 net 30 or similar means that an organization with a lengthy invoice-approval process can miss the discount rate, which results in lost savings potential and higher invoice-processing costs overall.
Recent Ardent Partners research shows that the average invoice processing cycle takes 12.4 days from invoice receipt until payment is scheduled, which misses the mark to capture early payment discounts by a mere 2.4 days. For that matter, an average of only 9.9% of suppliers even participate in a discounting program. While the invoice cycle time has shrunk considerably in the past 10 years (Ardent’s analysts found that it took an average of 20 days to process an invoice a mere decade ago), this still misses the mark on early payment discount capture.
Then, there’s also potential disagreement over when the “discount clock” starts. Suppliers may argue that the clock for capturing early payment discounts starts when the invoice is generated and sent to the buyer. The buyer, on the other hand, would argue that the discount clock starts when the invoice is received by the accounts payable team. Agreement on what date to consider as the discount period is thus paramount. Thankfully, technology such as eInvoicing has arisen to solve all these problems.
How can enterprises capture more early payment discounts?
The long and short of the situation is that enterprises interested in capturing more early payment discounts need to shrink invoice processing times dramatically. The clearest way to do this is through AP automation technologies, such as scan-and-capture solutions paired with workflows and sometimes with business networks that in some cases link the entire procure-to-pay workflow. We’ve explained business networks at Payables Place before, so I won’t belabor the point here, but suffice to say that the technology allows for suppliers and buyers to interact in many cases beyond invoice workflows.
Electronic invoicing (eInvoicing) capabilities also provide a keen technology solution to the discount clock problem. With an eInvoicing solution, invoice creation and invoice receipt can occur on the exact same day. This eliminates the argument over when the discount period begins and ends, and can also speed invoice approvals to further help capture more early payment discounts. End-to-end eInvoicing systems aren’t necessarily right for every enterprise, and in fact scan-and-capture solutions can in some cases more immediately deliver value to the organization.
If you’re looking into an eInvoicing or business network solution, a few solution providers to pay attention to are SAP Ariba, Tradeshift, and Inspyrus. Basware offers a dynamic discounting solution. Each of these solution providers offer eInvoicing and communication capabilities that allow enterprises to manage the invoice-approval workflow as well as collaborate more closely with suppliers through increased visibility and communication on both sides.
If scan-and-capture is more your level of interest, consider solutions like DocStar, Kofax, or Esker. Scan-and-capture technology chained with automated routing can be a powerful first step in the AP automation value chain, and shouldn’t be ignored in any enterprise’s thinking about automating accounts payable.
Early payment discounts can be a valuable facet of working capital management that buying organizations can leverage to possibly generate a higher rate of return overall than allowing cash to sit in other corporate accounts. While there are some challenges to capturing early payments, including inefficient processes and disagreement over the discount “clock,” the point remains that early payment discounts can offer a powerful annualized return that puts money back into an enterprise’s working capital accounts. Capturing early payment discounts isn’t easy, but it is certainly worthwhile.